CHAPTER-SIX

ACCOUNTING FOR RECEIVABLE

Receivables are all claims against individuals, organization or other debtors. They are
acquired by business enterprises in various types of transactions common being the sale
of goods (merchandise) or services on a credit basis.

Classifications of Receivables

 Receivables are frequently classified as:

 Accounts receivable:
 Are amounts owed by customers on account
 Are based on oral agreements are known as open accounts.
 Result from the sale of goods and services (often called trade receivables).
 Are expected to be collected within 30 to 60 days.
 Is usually the most significant type of claim held by a company
 Notes receivable:
 Represent claims for which formal instruments of credit are issued as
evidence of debt.
 are based on formal (written) instruments are called promissory notes
 Are credit instruments that normally require payment of interest and extend
for time periods of 60-90 days or longer.
 May result from sale of goods and services (often called trade receivables).
Note that: Accounts and notes receivables originating from sales transactions are called
Trade Receivables.

Internal control over Receivables

The management of a business enterprise installs the means of internal control over their
receivables. Thus, controls include

 Separation of the business operations and the accounting for receivables.

 Separation of these functions reduces the possibility of errors and embezzlement.
 Adequate control over account receivable
 Effective collection procedures should also be established.

NOTES RECEIVABLE
 A promissory note is a written promise to pay a specified amount of money on
demand or at a definite time.
In a promissory note, the party making the promise to pay is called the maker.
The party to whom payment is to be made is called the payee. The payee may be
specifically identified by name or may be designated simply as the bearer of the
note.

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  Notes receivable
Give the holder a stronger legal claim to assets than accounts receivable.
Are frequently accepted from customers who need to extend the payment
of an outstanding account receivable, and they are often required from
high-risk customers.
Notes receivable, like accounts receivable, can be readily sold to another
party. Promissory notes are negotiable instruments.

Types of Notes
 Interest bearing notes and non-interest bearing notes: there are two types of notes.

Non-interest bearing note: a note that does not provide for the payment of interest.

Interest bearing note: a note that provides for the payment of interest for the period
between the issuance date and the due date.

 The formula for computing interest is:

Interest =prt
Where; P=Face Value of Note (principal)
r = Annual Interest Rate
t = Time (in terms of one year)

 Due date: the date a note is to be paid is called the due date or maturity date.
 Maturity Value: the amount that is due on a note on date of maturity or due date is
maturity value. The maturity value of non-interest bearing note is the same with the face
amount or principal of the note.
Maturity value = principal + interest

 The interest rate specified on the note is an annual rate of interest. The time
factor in the computation expresses the fraction of a year that the note is
outstanding.
 When the maturity date is stated in days, the time factor is frequently the number
of days divided by 360. For example, the maturity date of a 60-day note dated
July 17 is determined as follows:

Term of note…………………………………….. 60 days

Days in July ……………………………31
Date of note…………………………… 17
Note’s days in July…………………….. 14

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 Days in August………………………… 31
Plus note’s days in July……………….. 14
Notes days to the end of August………. 45 45
Maturity date, September……………… 15

 When the due date is stated in terms of months, the time factor is the number of
months divided by 12.
 Notes may be held to their maturity date, at which time the face value plus accrued
interest is due.
 In some situations, the maker of the note defaults, and appropriate adjustment must be
made.

 A note is honored when it is paid in full at maturity.

 A dishonored note is a note that is not paid in full at maturity.
 If the lender expects that it will eventually be able to collect, the Notes Receivable
account is transferred to an Account Receivable for both the face value of the note
and the interest due.
 If there is no hope of collection, the face value of the note should be written off.
 The note receivable is recorded at its face value, the value shown on the face of the
note.

Example

1. On July 17, 2001, received a $12,000, 90-day, 10% notes from Adams Co. Assume
that the note was written to settle an open account.
Determine:
A) Due date for the note
B) Interest earned during the term of the note
C) Maturity value of the note
Prepare journal entries whether:
D) The note is honored on the maturity date
E) The note is dishonored on the maturity date
Solution:
a) Due Date:
Term of the note = 90
Days remaining in July 31 – 17 = 14
Remaining term of the note 76
Days in August 31
Remaining term of the note 45
Days in September 30
Remaining term of the note 15

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Since the remaining 15 days are less than the 31 days in October, the note is due on
October 15

B) Interest:
Calculated as Principal X Rate X Time
$12,000 x .10 x 90 days/360 days = $300
Time is calculated as the term of the note divided by 360 days for the year.
Time is always based on a 360-day year.
C) Maturity Value:
Calculated as Principal + Interest
$12,000 + $300 = $12,300
D) Note is honored:
7/17 Notes receivable 12,000
Accounts receivable 12,000
10/15 Cash 12,300
Notes receivable 12,000
Interest receivable 300
E) Note is dishonored:
7/17 Notes receivable 12,000
Accounts receivable 12,000
10/15 Accounts receivable 12,300
Notes receivable 12,000
Interest receivable 300
The difference between the two entries for 10/15 is the account to be debited.

Accounting for Notes Receivable

The typical retail enterprise makes most of its sales for cash or on account. If the account
of a customer becomes delinquent, the creditor may insist that the account be converted
into a note. In this way, the debtor is given more time, if the creditor needs more fund, the
note may be endorsed and transferred to a bank or other financial agency. Notes may
also be received by retail firms that sell merchandise on long term credit.
When a note is received from a customer to apply on account, the facts are recorded by
debiting the N/R account of the customer from whom the note is received.
Example: assume that the account of BM co., which has a debit balance of $900, is past
due a 20 day, 8% note for that amount, dated April 23, and is accepted in settlement of
the account.
The entry for the acquisition of the note is as follows
April 23 Notes Receivable----------------900

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 Accounts Receivable-----------900
After 20 days may 13 the note matures. The necessary entries on this date is
May 13 Cash--------------------904
Notes Receivable---------------900
Interest Income----------------- 4
If the above information is non interest bearing note the entry on maturity date is
May 13 Cash--------------------900
Notes receivable---------------900
Example: A 30 day, 12% note dated Dec.21, 2008, is accepted in settlement of the
account of Ambassel Company which has a balance of $4000. The entry to record the
transaction on:
1. December 21 settlement of the account
2. Adjusting entry for accrued ones, Dec.31,2008
3. Reversing entry Jan. 1, 2009
4. The necessary entry on the maturity date
Dec 21 Note receivable----------4000
Account receivable----------4000
Dec 31 Interest receivable-------13.33 (4000 x 10/360 x 12% = 13.33)
Interest Income----------------13.33
Jan. 1 Interest Income------------13.3
Interest receivable---------------13.3
Jan 21 Cash---------------------------4040
Note Receivable---------------4000
Interest income-------------------40 (4000 x 30/360 x 12% = 40)
Discounting Notes Receivable
A business may keep the note it has received until the due date or transfer it to a bank by
endorsement. If a note is transferred to a bank, it is said to be discounted and bank
charges interest for discounting the note. The discount (interest) charged is computed
on the maturity value of the note for the period of time the bank must hold the note. The
amount paid to the endorser is the excess of the maturity value over the discount or
interest charged by the bank. This amount is known as proceeds.
Example: Assume that a 90 day non-interest bearing note for $1350, dated August 21
is discounted at Lion Bank on September 20 at the rate of 7%.
Required: What is the maturity value of the note?
What is the number of days in the discount period?

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 What is the amount of the discount?
What is the amount of the proceeds?
Solution
Face value of the note dated Aug. 21------------------------------$1350
Maturity value of the note due Nov. 19 --------------------------- 1350
Discount period (Sep.20 - Nov.19) ----------------60 days
Discount on maturity value (1350 x 7% x6/36) -----------------15.75
Proceeds------------------------------------------------------------$1334.25

The entry for the transaction is

Sep. 20 Cash----------------------------------1334.25
Interest expense----------------------15.75
Notes Receivable----------------------1350
For instance: Misrak enterprise which has a 90 day, 9% notes receivable for $2000,
dated Nov.8 is discounted at Awash bank on Dec.3 at the rate of 10%.
Required: What is the maturity value of the note?
What is the number of days in the discount period?
What is the amount of the discount?
What is the amount of the proceeds?
Solution
Face value of the note dated Nov.8------------------------------------$2000
Interest on note (2000 x 90/360 x 9% = 45) 45
Maturity value of the note due Feb 6 ---------------------------------- 2045
Discount period (Dec 3 - Feb 6) -------------------------- 65 days
Discount on maturity value (2045 x 65/360 x 10%) ----------------- 36.92
Proceeds------------------------------------------------------------------$2008.08

The entry for the transaction is:

Dec 3 Cash ---------------------2008.08
Notes receivable----------------2000
Interest income------------------8.08
When the proceeds from discounted note is less than the face value is recorded as
interest expense and to the reverse the face value is less than the proceed the difference
is recorded as interest income.

Contingent liability
In the absence of a statement limiting responsibility, the endorser of a note is committed
in paying the note if the maker should default. Such potential obligations that will
become actual liabilities only if certain events occur in the future are called Contingent
liability that is in effect until the due date. Significant Contingent liabilities are
disclosed on the balance sheet or in an accompanying note.

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 Dishonored notes receivable
If the maker of the note fails to pay the obligation on the due date, the note is said to be
dishonored. A dishonored note is not negotiable, and for this reason the holder usually
transfers the claim including any interest due to the accounts receivable account. This
action is necessary in order to make the subsidiary ledger disclose the dishonor of the
note.
Example: If the $900, 20 day, 8% note received and recorded on April 23 had been
dishonored at maturity, the entry to charge the note, including the interest, back to the
customer’s account would have been as follows:
May 13 Account receivable B.M co-----------904
Notes receivable---------------------------900
Interest income -----------------------------4
When the discounted N/R is dishonored, the holder usually notifies the endorser of
such fact and asks for payment. If request payment and notification of dishonor are
timely, the endorser is legally obliged to pay the amount due on the note. The entire
amount paid to the holder by the endorser including the interest, should be debited to
account receivable of the maker.
Example: assume that the $2000, 90 day, 9% note discounted on Dec 3 is dishonored at
maturity by the maker, the entry to record the payment by the endorser, in general
journal form, would be as follows:
Feb 6 A/R ------------------2008.08
Cash----------------------2008.08
In some cases, the holder of the dishonored note gives the endorser a notarized
statement of the facts of the dishonor. The fee for this statement known as a protest fee is
charged to the endorser, who intern charges it to the maker of the note. If there had been a
protest fee of $5 in connection with the dishonor and the payment recorded above, the
debit to the maker’s account and the credit to cash would be $2013.08.

Uncollectible receivables
When merchandise or services are sold without the immediate receipt of cash, a portion
of claims against customers ordinarily proves to be uncollectible. This is usually the case
regardless of the care used in granting credit and the effectiveness of the collection
procedures employed.
The operating expense incurred because of the failure to collect receivables is variously
termed as expense or loss from uncollectible accounts or bad debts.
There are generally accepted methods of accounting for receivables that are deemed to
be uncollectible.
1) The allowance method or the reserve method, which makes advance provision for
uncollectible receivables.

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2) The direct write off method or direct charge off method, which recognizes the expense
only when specific accounts are believed to be worthless.

Allowance method of Accounting for Uncollectible

Most large business enterprise provide currently for the amount of their trade
receivables estimated to become uncollectible in the future. The advance provision for
future uncollectibility is made by an adjusting entry at the end of the fiscal period. As
with all periodic adjustments, the entry serves two purposes. In this instance, it
provides for:

 The allocation to the current period of the expected expense resulting from such
reduction
 The reduction of the value of receivable to cash expected to be realized from
them in the future
Example: a business enterprise has a balance of receivables $45,000 at the end of the
year. $2,500 is estimated to be uncollectible. The adjusting entry at the end of the
year is:
Uncollectible accounts expense----------------$2,500
Allowance for doubtful accounts-----------2,500

The balance in account receivable is the amount of the total claims against customers on
open account, and the credit balance of $2500 in allowance for doubtful accounts is the
amount to be deducted from account receivable to determine the expected realizable
value, frequently called the net realizable value (NRV). $2500 reduction in the asset
was transferred to uncollectible accounts expense, which will in turn be closed to
income summary.
Uncollectible account expense is generally reported on the income statement as an
administrative expense because the credit granting and collection duties are
responsibilities of department within the general administrative frame work.

Write – offs to the Allowance Account

When an account is believed to be uncollectible, it is written off against the allowance
account as in the following entry:
Allowance for doubtful accounts------------xxx
Accounts receivable-----------------------------xxx
During the year, as more accounts or portions of accounts are determined to be
uncollectible, they are written off against allowance for doubtful accounts in the same
manner. Instructions for write-offs should originate with the credit manager or other
designated official. The authorizations, which should always be written, serve as
objective evidence in support of the accounting entry.

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Sometimes a customer will pay the A/R after it was written off i.e. an A/R that has been
written off against the allowance account may be later collected. Recording the receipt
of cash is always a two-step process: first, the account receivable is reinstated (added
back into the general ledger), the exact reverse of the write-off entry, and second, the
cash is recorded and accounts receivable is reduced for the payment.

To reinstate the accounts receivable:

Accounts Receivable xxx
Allowance for Uncollectible Accounts xxx
To apply the cash received:
Cash xxx
Accounts Receivable xxx
Estimating Uncollectible
Before the accounts are closed and the financial statements are prepared at the end the
accounting period, an estimate of the expected amount of uncollectible should be made.
This estimate will usually be based up on past experience and modified in accordance
with current business conditions. Losses from uncollectible receivable tend to be
greater during periods of recession than in period of growth and prosperity.
The estimate is customarily based on either:
1) Percentage of Sales Method or
2) Percent of account receivable Method (Estimate based on Analysis of Receivable)
1) Estimate Based on Sales (Percentage of Sales Method)

A/Rs are acquired as a result of sales on account. The volume of such sales during the
year therefore is used as an indication of the probable amount of the account that will be
uncollectible. For instance if it is known from past experience that about 1% of charge
sales be uncollectable and the charge sales for particular year amount to birr 300,000 the
adjust entry for uncollectible accounts at the end of the year would be as follow :
Dec. 31 Uncollectible Account Expense----------------------3,000
Allowance for Doubtful Accounts------------------------3,000
The Percent of Sales Method uses one income statement account, Sales, to estimate the
change in another income statement account, Bad Debt Expense, for the period. This is
the amount of the required adjusting entry. This method is typically used by businesses
with a large number of customers with relatively uniform A/R balances. The balance in
the Allowance account is the balance in the ledger before adjustment plus the
adjusting entry for bad debt expense. The bad debt expense for the period is
calculated by multiplying the uncollectible percentage times the credit sales in the
period to determine the uncollectible accounts expense for the period. This will be the
amount of the adjusting entry.

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The estimate based on sales method of determining uncollectible account expense
widely used. In addition to its simplicity, it provides the best basis uncollectible
account expense to the period in which the related sales were made.

Estimate based on Analysis of Receivable

The process of analysis the receivable accounts some time called aging receivables. The
number and breadth of the time interval used will vary according to the credit term
granted to the customers.
The Percent of Receivables Method uses the balance in one balance sheet account,
Accounts Receivable, to estimate the balance in another balance sheet account,
Allowance for Uncollectible Accounts, at the end of the period. The adjusting entry
for bad debt expense is the difference between the balance in the ledger for the
allowance account before adjustment and the estimated balance in the allowance
account. After adjusting entry is posted, the balance in the allowance account will be
the desired amount (estimated balance).
The current balance of A/R is analyzed by use of an aging schedule to determine the
desired ending balance for the Allowance for Doubtful Accounts. The uncollectible
accounts expense for the period is determined based on the current (unadjusted)
balance in the Allowance, the desired ending balance in the Allowance account and any
write-offs of uncollectible accounts during the period.
Allowance for Doubtful Accounts
Beginning balance

Write-offs Solve for bad debt expense

Ending balance
Bad debt expense = ending balance + write-offs – beginning balance

However, if there have been more write-offs than expected, the balance before
adjustment in the allowance account may be a debit:

Allowance for Doubtful Accounts

Beginning balance

Write-offs Solve for bad debt expense

Ending balance
Bad debt expense = ending balance + write-offs+ beginning balance

Example: The balance of Allowance for Doubtful Accounts before adjustment at the end
of the period is $400 debit. Based on an analysis of Accounts Receivable, it was
estimated that $9,000 would become uncollectible. Determine the following:
a) The uncollectible accounts expense for the year.

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 b) The adjusting entry to be made of December 31.
c) The balance in Allowance for Doubtful Accounts after adjustment.
Solution:
a) Uncollectible accounts expense = 400 + 9,000 + 0 = 9,400
b) Uncollectible accounts expense ---------------9,400
Allowance for doubtful accounts--------------------- 9,400
c) 9,000

Direct Write-off Method of accounting for Uncollectible

The Direct Write-off Method records uncollectible accounts expense in the period
when the customer’s account is determined to be uncollectible. The entry to write-off
the account receivable is:
Uncollectible accounts expense ----------------------- xxx
Accounts receivable ---------------------------------------- xxx
In the period when a specific account is determined to be uncollectible. The Direct Write-
off Method violates the matching principle because it does not match revenues and
expenses in the same period.
The direct write-off method or the direct charge-off method is reasonable under some
situations:
1) If a company makes most of its sales for cash, and
2) If a company sells all or most of its output to few companies which financially strong.

In such situations and in many small business and professional enterprise, it is

satisfactory to defer recognition of uncollectible until the period in which specific
accounts are deemed to be worthless and are actually written off as an expense.
Accordingly, when the direct- write- off method is in use, the A/R will be listed on the
balance sheet at their gross amount, and no evaluation allowance will be used, and
there is no necessity for an adjusting entry at the end of the period.

Under this method, it is only when an account is believed to be uncollectible that it is

written-off as an expense.
The entry to write-off an account when it is believed to be uncollectible $42 is as follows:
May 10 Uncollectible Accounts Expense…………………. $4,200
A/Receivable-Horn Co………………………………….4, 200
If an account that has been written off is collectible later, the account should be
reinstated. If the recovery is in the same fiscal year as the write-off, the earlier entry
should be reversed to reinstate the account. To illustrate, let us assume that the account
written off in the May 10 entry above is collected in November 21 of the same fiscal
year. This entry to reinstate the account written off earlier in the year would be as
follows:
Nov.21 Accounts Receivable-Horn Co………………………4, 200
Uncollectible Account Expense…………………….4, 200

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Cash received in payment of the reinstated amount is recorded as:
Cash ……………………………………….. 4, 200
Account Receivable ……………………………… 4, 200

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